SDY Continues To Be A Buy

Summary

SDY has outperformed the market this year, and looks set to continue that trend.

The funds heavy exposure to financials and the consumer will help the fund once rates do rise.

The purpose of this article is to evaluate the attractiveness of the SPDR Dividend ETF (NYSEARCA:SDY) as an investment option. To do so, I will evaluate recent market performance, its unique characteristics, and overall market trends in an attempt to determine where the fund may be headed for the rest of the year.

First, a little about SDY. The fund seeks to closely match the returns and characteristics of the S&P High Yield Dividend Aristocrats Index. This index is designed to measure the performance of the highest dividend-yielding companies in the S&P Composite 1500 Index that have also followed a policy of consistently increasing dividends every year for at least 20 consecutive years. This is unique in that many dividend ETFs focus solely on high-yielding companies while SDY has a focus on a track record of raising payments.

Currently, SDY is trading at $81.25 and pays a quarterly dividend of $0.46/share, which translates to an annual yield of 2.26%. Year to date, SDY is up almost 10.50, not including its first quarter dividend payment. This far outperforms the Dow Jones industrial average (NYSEARCA:DIA) a popular benchmark, which has returned roughly 3.50% year to date. Given this outperformance, it is important to consider if this trend will continue, and I will outline below the reasons I believe that it will.

One, and most importantly, interest rates remain at historic lows, as the Fed again refused to increase rates in its most recent March meeting. This has surprised market participants, as most investors expected rates to climb this year.

For instance, back in January before the jobs report, 45% of traders had anticipated a March rate increase. After the positive January report, that number rose to over 50%. Yet, during March's meeting, Yellen stated the central bank will move "cautiously" with regards to further hikes, and has yet to announce when the next one will be.

What this means for investors: Dividend funds, such as SDY, which have benefited continuously from these low-rate policies, will continue to benefit. With rate expectations deflating, investors who exited dividend funds expecting bond rates to increase, will now be forced back into dividend funds as the hunt for yield continues. Assuming the Fed does not abruptly change course, and, based on Yellen's comments which were peppered with terms like "cautious" and "gradual" (to describe future hikes), this does not seem likely.

A second reason I like SDY has to do with its individual characteristics, compared to other dividend funds, as opposed to macroeconomic forces. To start with, SDY is heavily exposed to the financials sector, with almost 23% of the fund weighted towards that sector. The reason I view this as a positive is that once rates do start to rise, it will provide a nice hedge for the fund, as financials such as banks and insurance companies tend to do better in a rising rate environment. This is because a rising rate environment is usually correlated with a growing economy, so less loans will be written off, and the spread between what the banks charge in loans and pay in deposits also usually widens, which creates more profit for the bank. Additionally,

SDY has around a 20% weighting towards the consumer, with exposure in both the Consumer Staples and Consumer Discretionary sectors. I see this as a long-term positive. As the American workforce continues to heal, this should increase both consumer confidence and spending in the long term.

Most recently, in March, the Labor Department reported a 215,000 increase in payrolls, which "capped the best two-year period for hiring since the late 1990s, while the proportion of Americans in the labor force hit a two-year high". I expect these job gains to continue, and if we finally start to see wages rise, which should follow the job gains, the country will benefit from a following increase in consumer spending, directly impacting the companies that make up a good portion SDY.

Of course, investing in SDY is not without risk. Importantly, there is always the possibility that the Fed could alter its strategy and raise rates sooner, or more aggressively, than expected. This will surely be a negative for dividend funds, as investors will be taken by surprise and probably dump dividend funds in favor of less risky bonds or other assets that will begin paying higher yields.

Additionally, SDY has a fairly high weighting towards the utilities sector, at almost 15%. Utilities, in particular, have had a great run during this period of low rates, and will probably see a bit of a pullback once rates rise, which could hurt SDY. However, I do not see the Fed changing course anytime soon, as Yellen has repeatedly used dovish language in her speeches and has made a point of trying to calm the markets after Fed meetings. A swift reversal from her does not seem likely, nor would it be in the economy's interest.

Bottom line: SDY has performed extremely well since the recession, and has continued this trend throughout 2016, strongly outperforming the broader market since the start of the year. With the Fed continuing to put a hold on raising rates, dividend funds will surely benefit in the short-term. However, SDY looks to be besting the competition with its 10% gain this year, as similar funds such as VYM and VIG are up just over 5% and 6% year to date, respectively.

Clearly this has something to do with investors looking for dividend growth over just high yield, and SDY's commitment to only holding companies that increase their dividend is probably the main driver here. A continuously increasing dividend is more favorable to income seeking investors over the long-term rather than a high yield which may be gone tomorrow.

Given that the fund has a fairly cheap expense ratio of just .35%, is hedged nicely against future rate hikes, and looks likely to continue outperforming the market, I would encourage investors to take a serious look at this fund.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.